TESTING LENDING EFFICIENCY OF INDIAN BANKS THROUGH DEA

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1 TESTING LENDING EFFICIENCY OF INDIAN BANKS THROUGH DEA DR HARISH HANDA*; MS POOJA TALWAR**; DR MEERA MEHTA***; DR ALKA CHTURVEDI**** *ASSOCIATE PROFESSOR, DELHI UNIVERSITY (FORMERLY LECTURER, MASSEY UNIVERSITY NEW ZEALAND) **RESEARCH SCHOLAR SINGHANIA UNIVERSITY (RAJASTHAN) AND ASSISTANT PROFESSOR, DELHI UNIVERSITY ***ASSISTANT PROFESSOR, DELHI UNIVERSITY ****ASSISTANT PROFESSOR, DELHI UNIVERSITY ABSTRACT The paper attempts to examine the credit efficiency of the banking sector in India by using the Data Envelopment Analysis technique. India being a developing country with wide industrial base relies heavily on the banks for their credit demands. There have been many previous studies which have considered different models for checking the efficiency of the banks. The prime focus was to measure the lending efficiency of the banks. This takes into consideration the model in which one can measure loans as output and assets and deposits as inputs. In other words how well banks are transferring funds from house-holds to the industries, thereby performing the basic task for which they have been conceived. From deposit mobilization to lending a comparison was made and found that there is no significant difference between private and public sector banks. Also there has not been significant increase in the efficiency of bank. The paper concludes that as the economy grows and more and more opportunities come into the system banks must focus on increasing their credit efficiency so that they can provide a firm support in the financial market for the industries to develop. Prologue Bank of Hindustan, set up in 1870, was the earliest Indian Bank. Banking in India on modern lines started with the establishment of three presidency banks under Presidency Bank's act 1876 i.e. Bank of Calcutta, Bank of Bombay and Bank of Madras. In 1921, all presidency banks were amalgamated to form the Imperial Bank of India. Imperial bank carried out limited central banking functions also prior to establishment of RBI. It engaged in all types of commercial banking business except dealing in foreign exchange. Reserve Bank of India Act was passed in 1934 and Reserve Bank of India (RBI) was constituted as an apex bank without major government ownership. Banking Regulations Act was passed in This regulation brought Reserve Bank of India under government control. Under the act, RBI got wide ranging powers for supervision & control of banks. The Act also vested licensing powers & the authority to conduct inspections in RBI. In 1955, RBI acquired control of the Imperial Bank of India, which was renamed as State Bank of India. In 1959, SBI took over control of eight private banks floated in the erstwhile princely states, making them as its 100% subsidiaries. 1

2 RBI was empowered in 1960, to force compulsory merger of weak banks with the strong ones. The total number of banks was thus reduced from 566 in 1951 to 85 in In July 1969, government nationalised 14 banks having deposits of Rs.50 crores and above. In 1980, government acquired 6 more banks with deposits of more than Rs.200 crores. Nationalisation of banks was to make them play the role of catalytic agents for economic growth. The Narsimham Committee report suggested wide ranging reforms for the banking sector in 1992 to introduce internationally accepted banking practices. Review of Literature Analysis of efficiency of financial institution has gained a lot of importance in the last few years. Various approaches have been defined to determine the efficiency of the financial institutions. These approaches broadly fall under two types-parametric and non parametric. The primary difference between these as explained by Berger and Humprey (1997), is the assumptions imposed on the data in terms of a. The functional form of the best practice frontier b. Consideration of random error c. If there is a random error the probability distribution assumed for the inefficiencies. Thus the shape of the frontier and the distributional assumptions on the random error and inefficiency are key parameters on which the main approaches to determine the efficiency of financial institutions differs. The non parametric programming was initiated by Charnes et al. They gave relatively little specification of the best practice frontier as in the case of nonparametric approaches such as Data Envelopment Approach (DEA) and Free Disposal Hull (FDH). The most widely used nonparametric technique is DEA, as it is proven to be valuable tool for strategic, policy and operational problems, besides to develop benchmarks. At present, DEA has been widely accepted as a tool to measure the efficiency of the financial institutions over the parametric methods. Bauer et al applied different approaches to the study of the efficiency of the US banks over the period They found that nonparametric methods were generally consistent with each other as far as identifying efficient and inefficient firms were concerned, but parametric and nonparametric measures were not consistent with each other. The wide acceptance of DEA as a measurement tool for measuring efficiency of the financial institution can be attributed to certain strengths of this approach. The main advantages of using DEA are as follows. The data may not necessarily assume any functional form. DEA leads to a comparison of one Decision Making Unit against peer or combinations of peer. The units of input and output may vary as they do not affect the value of efficiency measure. This model can handle multiple inputs and outputs. However, there are a few limitations as well. There is no assumption of statistical noise, thus the noise element gets reflected in the measured inefficiency of the DMU. Further DEA does not give absolute efficiency measures. DEA results are sample-specific. An inherent limitation of this nonparametric method is that it makes hypothesis testing difficult. The Constant Returns to Scale model Charnes et al. proposed this model with the assumption of constant returns to scale. It s also called the CCR model after the researchers Charnes, Cooper and Rhodes. The present study suggests that banks produce certain inputs to produce certain outputs. Thus, the efficiency of 2

3 banks is measured in terms of how efficiently they are able to utilize their inputs given their outputs. In this model, efficiency is measured by the ratio of weighted outputs to weighted inputs. The ratio is of the form: Where u and v are weights for output (. ) and inputs (. ) respectively. Assume that for each of the n firms there is a data on K inputs and m outputs and represented by column vectors and respectively for the i th firm. This may be expressed as u / v where u is MX1 vector of output weights and v is KX1 vector of input weights. To arrive at the optimal weights, we define the following linear programming model as: Max u, v (u / v ) s.t. u / v 1, j=1, 2, 3, n. u,v 0..(1) Solving Eq. 1, values for u and v may be obtained such that the efficiency measure for each firm is maximised. A pertinent constraint with this model formation is that it can have infinite number of solutions. Thus an additional constraint is added, v x i =1, so the problem can be removed. The new model, known as the transformation model, thus becomes Max u, v (u ) s.t. v = 1 u - v 0, j=1, 2, 3, n. u,v 0..(2) This form in Eq. 2, is known as the multiplier form of the DEA linear programming problem. Using duality in linear programming, an equivalent envelopment form of this problem may be obtained. Max Θ, λ (Θ) s.t. - + Yλ 0 Θ - Xλ 0, j=1, 2, 3, n. λ 0..(3) where Θ is scalar and λ is a NX1 vector of constraints. The efficiency for the j th DMU is reflected by the value of Θ. For each DMU taken in study a separate linear programming model would be solved. The technically efficient DMU will have a Θ=1, and all other DMU will have a Θ < 1, implying that the efficiency scores of all other DMU s will be measured relative to the 3

4 technically efficient units that have a score of Θ=1. In this study, each bank under observation is considered a DMU. Research Methodology The paper evaluates the technical efficiency of the banks operating in India using the DEA methodology. An important aspect in the dynamic business environment, in the wake of continuous reforms initiated by the RBI, is that the efficiency scores may vary from year to year. Hence a separate frontier was derived for each of the years taken during the study period. Choice of Input and Output It has been a matter of constant debate when it comes to defining inputs and outputs. There are mainly two approaches that have been discussed in existing literatures. The first is the intermediation approach. Here banks are viewed as intermediaries between the provider of the funds and users of the funds. In this approach, deposits are regarded as being converted into loans. This approach takes into account interest expense, which accounts for a large proportion of bank s cost. In this approach, output may be taken as money value of deposits and loans, and the inputs considered include money value of labour, fixed assets and equipments, and loanable funds. In contrast the second approach, production approach is the one in which banks are considered to be producing deposits and loans using capital and labour. This approach takes into account physical quantities of input and output, and does not assign monetary value to inputs or outputs. This approach does not take into account the interest costs, hence the criticism. The paper uses the second approach. The data has been mostly secondary data i.e. collected from various places like, Prowess, BSE website, reports published by Govt. of India, Annual Reports of Banks etc. Sampling Unit The banking index of BSE i.e. BANKEX served as the sampling for the data because it is a robust measure for measuring the performance of the banking sector of India. It has been scientifically designed and therefore provides the basis for the calculations and functions used to analyse the data. The study is based on a period of six years i.e Thus all the data used pertains to the same period. 4

5 Analysis and Interpretation of data Efficiency of Banks ranking on the basis of average ranking on the basis of the last year 1 IDBI Kotak Mahindra 2 Oriental Bank Yes Bank 3 Kotak Mahindra ICICI 4 Yes Bank IDBI 5 Bank of India Axis Bank 6 Indian Overseas Bank Federal Bank 7 Canara Bank IndusInd 8 Karnataka Bank Karnataka Bank 9 Punjab National Bank Indian Overseas Bank 10 Union Bank of India Canara Bank 11 State Bank of India Bank of Baroda 12 Federal Bank Bank of India 13 ICICI Punjab National Bank 14 Bank of Baroda HDFC 15 Allahabad Bank Union Bank of India 16 Axis Bank Oriental Bank 17 HDFC Allahabad Bank 18 IndusInd State Bank of India On the basis of average performance of the five years IDBI, Oriental Bank and Kotak Mahindra were top performers. But if the last year s performance is seen then Kotak Mahindra, ICICI and Yes Bank has fared well. One of the most worst performing bank has been SBI which scored last on the previous year and eleventh on the average. Public Vs Private Banks Efficienc y Group Statistics public_ vs_priv ate N Mean Std. Deviation Std. Error Mean Public Private So far as the difference in performance of the private sector and public sector banks are concerned very significant differences were not found. In terms of giving loans both public sector and private sector banks have performed equally. 5

6 Independent Samples Test Levene's Test for Equality of Variances t-test for Equality of Means 95% Confidence Interval of the Difference Sig. (2- Mean Std. Error F Sig. t df tailed) Difference Difference Lower Upper efficiency Equal variances assumed Equal variances not assumed Bank Wise Dependent Variable: efficiency Mean Difference (I-J) Std. Error Sig. 95% Confidence Interval (I) company_wise (J) company_wise Upper Lower Bound Bound IDBI Allahabad bank * Axis bank * Bank of Baroda * Bank of India * Canara Bank * Federal Bank * HDFC ICICI * Indian Overseas Bank * IndusInd Karnataka Bank * Kotak Mahindra * Oriental Bank * PNB * SBI * Union Bank of * India Yes Bank * IDBI has performed significantly different from all other banks but in a negative sense. 6

7 Bankex Vs Sensex Regression As observed by the graph there exists a very high correlation between Sensex and Bankex, this is due to the fact that banking and economy are very closely related and hence they follow each other closely. Regression Regression Statistics Coefficients Multiple R R Square β Adjusted R β Square Standard Error Observations 80 Depending on the Sensex one can predict the Bankex future as Bankex = * Sensex 7

8 Year wise Comparison On applying T-test it was found that there is not much significant difference in efficiency between the years except for the year 2004 and others. This explains that banks have not been increasing their efficiency and continue to go at the same pace. Efficiency Descriptive Std. 95% Confidence Interval for Mean N Mean Deviation Std. Error Lower Bound Upper Bound Minimum Maximum Total ANOVA Efficiency Sum of Squares Df Mean Square F Sig. Between Groups Within Groups Total Dependent Variable: efficiency Multiple Comparisons 95% Confidence Interval Mean Upper (I) year (J) year Difference (I-J) Std. Error Sig. Lower Bound Bound LSD * * * * *

9 Future Predictions Life sciences Food and Agriculture Infra Engineering Technology media and telecommunication Others Growth The following sectors are the sunrise or priority sectors of the Indian Market. Either they do not have investors ready or they are being developed by govt. The banking sector has more or less neglected the growth opportunities in these sectors. Based on the different statistics predicted by Govt. of India and McKinsey, the various growth rates have been taken into consideration and growth predicted at the given rates predict that by 2015 banking sector is going to grow at about twice the volume it is operating at now. Year Life sciences food and agriculture infra Engineering Technology media and telecommunication Others percent share increase redistribute increase redistribute increase redistribute increase redistribute increase redistribute increase But the problem with the previous growth model was that all the sectors are not capable of absorbing the same amount of funds, hence there are funds that are left unused. The solution could be that the funds at the end of each year are invested at the ratio in which they are invested now. 9

10 Conclusion The efficiency of banks has been more of less remained the same over the years except for the year 2004 from which there has been significant improvement. There is not much difference in the efficiencies of Private Sector and Public Sector Bank. There is significant difference in the efficiencies of IDBI and other banks. If we see the investment patterns and predict at the low level growths as predicted by govt. of India and other institutions, the banking sector is expected to grow to double of the present conditions. Bibliography Anand, S. C. (1993). Is Priority Sector Lending Still a Drag on Profitability. Indian Banks' Association Bulletin. Ayadi, O. F., Arinola, O. A., & Omolehinwa, E. (1998). Bank Performance Measurement in a developing economy: An application of Data Envelopment Analysis. Managerial Finance. Agarwal P (2000) Regulation and reform of the financial sector in India: an analysis of the underlying incentives. In: Kahkonen S, Lanyi A (eds) Institutions, incentives and economic reforms in India. Sage Publications India Pvt, New Delhi Alam ISM (2001) A non-parametric approach for assessing productivity dynamics of large US banks. J Money Credit Bank 33: Ali AI, Gstach D (2000) The impact of deregulation during on banking in Austria. Empirical 27: Ariss RT (2008) Financial liberalization and bank efficiency: evidence from post-war Lebanon. Appl Finan Econ 18: Arun TG, Turner JD (2002) Financial sector reforms in developing countries: the Indian experience. World Econ 25: Arun TG, Turner JD (2004) Financial sector reforms and corporate governance of banks in developing economies: the Indian experience. South Asia Econ J 4: Ataullah A, Cockerill T, Le H (2004) Financial liberalization and bank efficiency: a comparative analysis of India and Pakistan. Appl Econ 36: Barr, R. S., Killgo, K. A., Siems, T. F., & Sheri, Z. (2002). Evaluating the productive efficiency and performance of US commercial bank. Managerial Finance. IBM Business Consulting Service. The Paradox of Banking McKinsey&Company. (2007). Indian Banking:Towards Global Best Practices. Process Innovation in Indian Banking Industry. (2009, February). The Indian Banker. 10

11 Appendix 8.1 Weightage of Bankex BANKEX Company Name Weight Company Name Weight Allahabad Bank 1.16 IndusInd Bank 1.19 Axis Bank 8.87 IOB 0.94 Bank of Karnataka Baroda 4.15 Bank 0.27 Bank of India 3.42 Kotak Mahindra 5.03 Canara Bank 3.13 Oriental Bank 1.34 Federal Bank 0.86 PNB 5.54 HDFC Bank SBI ICICI Bank Union Bank 2.52 IDBI Bank 1.68 Yes Bank Efficiency Table DEA Efficiency Allahabad Bank Axis Bank Bank of Baroda Bank of India Canara Bank Federal Bank HDFC ICICI IDBI Indian Overseas Bank IndusInd Karnataka Bank Kotak Mahindra Oriental Bank Punjab National Bank State Bank of India Union Bank of India Yes Bank